BDB Law’s “Tax Law for Business” appears in the opinion section of Business Mirror every Thursday.

Bad debts

FOR the purpose of determining the taxable income of a taxpayer engaged in trade or business
or engaged in the practice of a profession, Section 34(E) of the Tax Code of 1997 allows the
deductibility of debts actually ascertained to be worthless.

Revenue Regulations (RR) 5-99, as amended by RR 25-02 provides the requisites for valid
deduction of bad debts from gross income, to wit: 1) There must be an existing indebtedness
due to the taxpayer which must be valid and legally demandable; 2) The same must be
connected with the taxpayer’s trade, business or practice of profession; 3) The same must not
be sustained in a transaction entered into between related parties enumerated under Section
36(B) of the Tax Code of 1997; 4) The same must be actually charged off the books of accounts
of the taxpayer as of the end of the taxable year; and 5) The same must be actually ascertained
to be worthless and uncollectible as of the end of the taxable year.

Before a taxpayer may charge off and deduct a debt, he must ascertain and be able to
demonstrate with reasonable degree of certainty the uncollectibility of the debt. The
commissioner of internal revenue will consider all pertinent evidence, including the value of the
collateral, if any, securing the debt and the financial condition of the debtor in determining
whether a debt is worthless, or the assigning of the case for collection to an independent
collection lawyer who is not under the employ of the taxpayer and who shall report on the legal
obstacle and the virtual impossibility of collecting the same from the debtor and who shall issue
a statement under oath showing the propriety of the deductions thereon made for alleged bad
debts. Thus, where the surrounding circumstances indicate that a debt is worthless and
uncollectible and that legal action to enforce payment would, in all probability, not result in the
satisfaction of execution on a judgment, a showing of those facts will be sufficient evidence of
the worthlessness of the debt for the purpose of deduction.

In Court of Tax Appeals Case 8541, the tax court disallowed the deductibility of a taxpayer’s bad
debts from its gross income due to the taxpayer’s failure to comply with the requirements of
establishing the worthlessness of a debt. In this case, the petitioner taxpayer was able to
convincingly establish the following: i) existence of indebtedness due to petitioner; ii) the said
indebtedness due to petitioner is in connection with its business; and iii) the amounts due to
petitioner were actually charged off in its books of accounts.

However, petitioner failed to show supporting documentary evidence to prove that it exerted
diligent efforts to collect and that its receivables are worthless. The tax court noted that the
testimony of petitioner’s accountant that the company’s agents and president repeatedly made
several follow-ups and visits to the petitioner’s debtors to demand payment is simply self-
serving evidence. Petitioner, likewise, failed to establish that it is not related to its debtors, which
is an equally important requirement for deductibility of bad debts expense pursuant to Section
3(3) of RR 5-99, as amended by RR 25-02.
Citing GR 118794, the tax court ruled that, in the absence of supporting documentary evidence,
petitioner’s allegation and the testimony of its witness are too weak and unconvincing to
establish that petitioner exerted diligent efforts to collect and that its receivables are worthless.
More so, petitioner failed to show compliance regarding the sending of statement of accounts
and collection letters, giving/assigning of the account to a lawyer for collection, and the filing of a
collection case in court.

Petitioner argued that its debtor’s total current liabilities exceeded its total current assets which,
according to petitioner, may have an effect on its ability to continue operating in the normal
course of business. However, the tax court brushed aside such argument ruling that such a
financial condition should not ipso facto lead to a conclusion that the debtors debt to petitioner
will not anymore be paid even in the future. In fact, debtors total assets of P357,101,000
consisting of total current assets of P248,304,000 and total noncurrent assets of P108,797,000
is more than enough to pay its total liabilities of P250,138,000.

Hence, to ensure deductibility of worthless receivables, it is important to document every effort

to collect the same for a mere oral testimony does not suffice.

*****

Atty. Rodel C. Unciano is a senior associate of Du-Baladad and Associates Law Offices, a
member-firm of World Tax Services Alliance. To contact the author of this column: Atty. Rodel
C. Unciano at rodel.unciano@bdblaw.com.ph or call 403-2001 local 140. The article is for
general information only and is not intended, nor should be construed as a substitute for tax,
legal or financial advice on any specific matter. Applicability of this article to any actual or
particular tax or legal issue should be supported therefore by a professional study or advice.